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New York Fed economists Marc Saidenberg and Philip Strahan find that despite the growth of alternative sources of funding, banks still play a significant part in providing liquidity to large corporations, particularly during periods of economic stress. They conclude that by providing a back-up source of liquidity, banks help insulate large corporations from market shocks.

Over the past three decades, corporations have increasingly turned to securities markets in place of banks to obtain credit. Today, most large, highly rated corporations rely on the commercial paper market to fulfill their short-term credit needs. Commercial paper, an unsecured form of debt, is attractive because it usually carries an interest rate lower than that on a comparable bank loan.

Under certain circumstances, however, turmoil in the financial markets can cause the interest rates on commercial paper to rise. For example, in the fall of 1998, after the Russian government announced its intention to default on its bonds, the yield spread between commercial paper rates and short-term Treasury bill rates more than doubled.

According to Saidenberg and Strahan, firms routinely secure a commercial paper backup line of credit with a bank to protect against such rate hikes. Saidenberg and Strahan show that in the fall of 1998, as borrowing in the commercial paper market grew too expensive, many businesses drew on these preexisting lines of credit until interest rates stabilized.

Saidenberg and Strahan also find that banks have an edge over other financial institutions as providers of liquidity insurance because they offer committed lending and deposit-taking services. Banks tend to experience deposit inflows when liquidity elsewhere dries up. This inflow of deposits enables banks to economize on the quantity of cash and safe securities they hold throughout the year. Banks can then offer liquidity insurance to customers at a lower price.

To provide liquidity on demand, other financial institutions would need to maintain large amounts of cash and safe securities as assets. Saidenberg and Strahan find that such an approach would be costly because these assets generally do not provide a high rate of return.